Irrespective of numerous liquidity injections and bailouts, another month has passed and the eurozone remains in dire straits. But loose monetary policy, and the potential for additional central bank action should the need arise, has (for now) appeased market stakeholders. While equity markets fell in May, they have since recovered the majority of their declines in the first few weeks of June. This is true despite enormous exogenous risk, including a possible eurozone breakup and the looming U.S. fiscal cliff.
While there are rumors of imminent coordinated action by world central banks as well as forthcoming fiscal stimulus from regional governments, the plight of the eurozone remains. Periphery countries are over-indebted, over-budget, and uncompetitive. That will continue regardless of a tighter fiscal and monetary union. The eurozone needs to get its economies growing again, but Germany continues to insist on needless austerity. It is unfortunate that the eurozone must be pushed to the brink before proper action occurs. Accordingly, the MSCI Europe, Australasia, and Far East Index Fund (EFA) -- which has a 28% weighting to euro area countries -- is trading near three-year lows. The eurozone crisis is unresolved, but there is some solace; developed international markets in aggregate have less than 6.0% exposure to countries deemed troubled (the PIIGS), are trading at discount valuations to U.S. markets, and now yield over 3.60%.
The most logical time for governments to be budget conscious is amid economic boom. A government can tame its own spending and/or raise taxes while the private sector is expanding rapidly. This improves budget deficits and lowers outstanding government borrowing, while at the same time serving to keep inflation in check. Conversely, when the private sector is in recession, the government can attempt to soften the economic contraction by adding more jobs and lowering taxes. In a perfect world, this would always be done on the margin and as a buffer to prevent the economy from overheating or collapsing. But what would seem obvious is lost on policy makers. Eurozone governments are being asked to cut spending and raise taxes while the private sector is in recession. The outcome to date in Europe should be of no surprise. And for the second year in a row, the United States is currently positioned to raise taxes and to cut spending during a feeble recovery.
In January 2013, automatic spending cuts go into effect and both the Bush-era tax cuts and middle class AMT protections expire. According to a Congressional Budget Office (CBO) report, real GDP in the U.S. will decline by 1.3% in the first half of 2013 if Congress fails to act. From the CBO report:
The resulting weakening of the economy will lower taxable incomes and raise unemployment, generating a reduction in tax revenues and an increase in spending on such items as unemployment insurance. Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession.
We expect Congress to postpone this looming fiscal tightening for one additional year, just as it did in 2011. And like last year's debt ceiling debacle, we expect resolution to occur at the last possible minute. But while an unresolved fiscal cliff will surely cause a recession, kicking the proverbial can to 2014 will not necessarily prevent one from occurring.
U.S. reports continue to reveal a slow growing economy. Jobs are being created, real hourly earnings and real weekly earnings are up, initial claims are comfortably below 400,000, housing starts and permits continue to improve, and manufacturing is expanding. Incoming data is generally positive, but weaker than what participants and policy makers want. We still believe the U.S. economy remains on the path of slow growth and not one of recession, but data has softened recently and could, in time, lead to a more defensive posture.
We think it bears stating that, should even all exogenous risks happen to be resolved most positively, returns across asset classes are still likely to be below long-term historical averages over the coming five to 10 years. Broad U.S. equity market valuations remain stretched and fixed income yields are at historical lows. Longer-term expectations, even with favorable resolutions to the above risks, must be tempered.
Disclosure: Black Cypress Capital has a long position in EFA.